The Final Cut

The unsuspecting middle class is on a collision course with the estate tax

Your dear old mother’s funeral was yesterday. She led a modest life, but a good one. And she left you and your brother and sisters a nice little legacy: the house you grew up in (can you believe Mom and Dad only paid $39,000 for it back in 1960?), the old three-room cottage at the lake, Grandma’s jewelry, and what’s left of Dad’s 401(k).

Oh, wait, that’s the IRS on the phone. They say you owe them half-a-million dollars.

That’s a scene that’s being played out in close to 100,000 homes across America in 1999, and it’s a scene that’s likely to be repeated more and more frequently in the years ahead.

The Great Middle

Pollsters and politicians know that if you ask Americans to define themselves, the great majority (over 80 percent) describe themselves as “middle class.” Class agitators have gnashed their teeth for a century as poor Americans self-identified upward in a kind of reverse Lake Wobegon syndrome—a land where everyone claims to be average, even those who aren’t.

Sociologists, meanwhile, can only debate why the obviously privileged so doggedly refuse to acknowledge their status. Whether it’s due to a residual sense of egalitarianism or to a stubborn identification with things bourgeois, most Americans who by any meaningful definition should be counted as wealthy persist in describing themselves as middle class. Indeed, according to a recent U. S. Trust “Survey of Affluent Americans,” 81 percent of people among the wealthiest Americans described themselves as “middle class” or “upper middle class.”

Thus many are surprised—mortified, if you will—to discover that that’s not the way the IRS sees them.

After all, estate taxes are for the rich and superrich, right? They’re for the trust fund set, for people with yachts and jets and polo ponies. Actually, it turns out that the bar is set quite a bit lower. Because of the enormous appreciation in real estate and stock prices, many people who have simply owned a home or invested for retirement have earned (or are about to earn) the final reward of being taxed for the simple act of dying. In the words of Florida estate planning attorney Craig Hersch, it’s the principle of “I Worked, Saved, and Invested for this?”

The genuinely rich do, of course, bear the brunt of the estate taxes collected by federal, state, and local tax collection agencies each year. And if breaking up hereditary concentrations of wealth is a goal, as defenders of the estate tax system contend, then it does to a certain extent succeed. According to Citizens for Tax Justice, a liberal Washington, D.C., think tank that studies tax issues, for estates worth more than $20 million, less than one-third of net assets wind up in the hands of heirs.

But whatever the wisdom or “justice” of this progressivity (about which more later), the fact is that more and more people who have never considered themselves rich are unwittingly moving into that class. It’s like a Publisher’s Clearinghouse Sweepstakes in reverse. Imagine Ed McMahon and a camera crew showing up at your funeral with a big Styrofoam bill saying “Congratulations! You Owe $500,000!”

A Tax Deferred. . .

In the main it is the long stock market boom, particularly in the form of tax-deferred accounts like 401(k)s, 403(b)s and IRAs, that is thrusting so many Americans into the ranks of the “rich.”

Nearly half of all Americans now expect to fund their retirement with tax-deferred accounts, up from just 6 percent in 1980. Not too long ago, most people retired on pensions. The assets from which those pensions were drawn did not, of course, count toward an individual’s net worth or estate. Moreover, pensions die with an individual, or their spouse. Tax-deferred retirement accounts, by contrast, are owned assets. Thus, a worker who lives on a pension for 30 years might have a very small estate, while a worker with an identical work history and post-retirement income—but who is relying on 401(k) savings—would have a much larger estate.

And it gets worse. The money inside the retirement account is not taxed until it is withdrawn, so it counts towards the decedent’s asset ceiling, thus raising his death tax rates while still being subject to normal income taxes. Ouch! On the other hand, at least the 401(k) worker, in contrast to the pensioner, does wind up having something to give away, subject to the extra tax.

And it is a hefty one. Federal estate taxes start at 37 percent and quickly climb up to 55 percent. With surcharges, “excess accumulation” taxes, state and local fees, and probate costs, marginal rates can easily top 60 percent. The hit on a tax-deferred IRA or 401(k) can top 80 percent.

How many people fall into the category of “I never knew I was rich until I was dead”? It can be tricky to calculate other people’s net worth, since individuals tend to understate the value of their estates. This is because estates include liquid items like stocks, bonds, and bank accounts but also homes, business interests, debts owed, life insurance (which converts many unsuspecting people from “middle class” to “rich” upon drawing their last breath), art, cars, and all other personal possessions. When they start adding things up, many people are surprised to find how quickly they reach $650,000, the threshold at which estate taxes begin for an individual this year.

In 1996, only about 3 percent of Americans who died were subject to estate tax. But that number is growing rapidly. Federal Reserve data suggest that over 6 percent of U.S. households have a net worth sufficient to subject them to the estate tax if they were to die today, and every uptick in the market adds new households to the club. The IRS numbers are revealing, even if they don’t tell the whole story. By 2004, they expect the number of estate tax forms to be filed to rise by 52 percent (to 143,000 per year), and as the pace of the Baby Boomers’ long and slow goodbye hastens, that figure looks to increase even further.

The Wrath of Oprah

An often-heard rationale for the estate tax is that society has “allowed” you to get rich, and that you are just “paying it back.” Fair enough. The problem, though, is that you already have. As talk show hostess Oprah Winfrey lamented a couple of years ago, “I think it’s so irritating that once I die, 55 percent of my money goes to the United States government.” Added Winfrey: “You know why that’s so irritating? Because you have already paid nearly 50 percent” on that money.

All the money that is in your estate, unless you’ve been laundering drug money or serially cheating on your taxes (in which case estate planning may not be the most pressing of your legal concerns) has already been taxed either as income or dividends. Quite likely, it has been taxed more than once. The only exception to this is long-term capital gains, which your heirs inherit on a “stepped up” basis; that is, their basis price for the security is its market price at the time of the decedent’s death. But even this “bonus” to the would-be inheritor is less valuable than it seems, since by valuing the security at the market rate it is subject to the higher death tax rate (up to 55 percent) rather than to the long-term capital gains rate of 20 percent.

At the same time, precious little attention is paid to the estate tax’s wicked stepsister, the Gift Tax. The Gift Tax only exists as a supplement to the estate tax—without it, people would simply transfer their wealth while they were alive. As it is, people who give gifts worth more than $10,000 have the excess counted against their “unified credit.” That is, those gifts ultimately count against the amount you have in your estate when you die. So if your estate does wind up being subject to taxation, those gifts will come back to haunt you.

This necessity has resulted in some (surprise!) unforeseen consequences, mandating a federal presence in what should be the most personal transactions. Thus, if your neighbor’s house burns down and you want to help him out with a check for $25,000—the IRS wants to know about it. If your brother is down on his luck and you want to help him out, maybe give him a car—the IRS wants to know about it. If a grandmother wants to give her granddaughter a cherished family heirloom—the IRS wants to know about it. These donors might be surprised by claims emanating from Washington that our tax code is designed to encourage giving.

Incidentally, the Gift Tax includes forgiveness of debts. Thus, if in a moment of kindness, charity, or magnanimity, you “forgive” a friend or relative’s debt of over $10,000, your estate could conceivably wind up paying 55 percent of that amount to the federal government. Some good deeds may go unpunished, but none that are over the statutory limit go untaxed.

How Did We Get Here?

Estate taxes have come and gone throughout American history, being enacted during three wars and repealed each time in the after-war years. The current incarnation was initiated in 1916 and has passed through various mutations, most notably the Tax Reform Act of 1976 that codified the Gift Tax and the generation-skipping transfer tax, the Economic Recovery Act of 1981, and the Omnibus Reconciliation Acts of 1987 and 1993.

Conservatives have wanted to kill the death tax for decades, but only recently have gained enough momentum to be taken seriously. But it isn’t just conservatives who have estate taxes in their sights. Estate taxes can be particularly disastrous for family businesses and farms, which often have to be sold just to pay the tax.

Some respite came with the Taxpayer Relief Act of 1997. The amount exempted from the estate tax, which had not been adjusted despite ten years of inflation, was raised from $600,000 to $625,000 in 1998 and $650,000 this year, eventually reaching $1 million in 2006. The annual gift tax exemption, which at $10,000 per person per year had also been seriously eroded by inflation, will be indexed in the future. And some provision was made for deductions for family businesses and land conservation.

Liberals like Henry Aaron of the Brookings Institution found such “modest reforms” to be quite acceptable. But critics charge that these steps merely make up ground, and that they don’t address the fundamentally unsound and unfair nature of estate taxes. In other words, they still want the estate tax scrapped altogether.

That may happen. California Republican Rep. Chris Cox has introduced legislation that would eliminate the death tax. The bill had almost 200 co-sponsors as of press time, and has attracted the support of a fairly broad coalition of anti-estate tax forces including the U.S. Chamber of Commerce and the National Federation of Independent Business. More recently, House Ways and Means Committee members Jennifer Dunn, Republican of Washington, and John Tanner, Democrat of Tennessee, introduced legislation to phase out gift and estate taxes over a ten-year period.

Reformers argue that estate taxes are a drain on the capital formation that is crucial to job creation and economic growth. They also argue that the estate tax doesn’t even bring in that much money. In 1998, for instance, it generated $23 billion, about 1 percent of federal revenues.

Opponents see the estate tax as a fair means of progressively redistributing wealth from those who can most easily afford it. Besides, they point out, the tax doesn’t harm anyone directly since it is only collected when the taxee is presumably beyond the need for material goods. Citizens for Tax Justice concludes that, “prudently progressive taxes can mitigate the inequalities that capitalism demands without stifling incentives. In this regard, the estate tax, with its ‘disincentives’ limited mainly to ex-people, is a star.”

Opponents can also take comfort in bipartisan Congressional estimates showing that even though federal estate tax receipts are relatively modest right now, they are poised to increase by 44 percent over the next nine years, to $33.1 billion.

Cut the Tax, Cut the Charity?

Opponents of cutting the estate tax argue that tax deductions are a principal—perhaps the principal—reason that people give money to charity. And many nonprofits apparently agree. Independent Sector, the Washington-based lobbying association of nonprofits, has argued, plausibly enough, that cutting the estate tax would decrease charitable bequests. Would the elimination of the death tax result in a diminution of charitable dollars?

The honest answer is: nobody knows. Significantly, however, a new study by the Treasury Department’s Office of Tax Analysis found that over 80 percent of people whose estates were subject to tax didn’t leave so much as a dime to charitable bequests—and the smallest estates subject to taxation were also those which bequeathed the smallest percentage of their assets to philanthropic causes. Estates valued at between $600,000 and $1 million—the creeping middle—dedicated just 3 percent to charity. Clearly, these people at the lower end of the estate tax net didn’t consider charitable bequests a major tax-avoiding tool. And a 1996 Independent Sector poll of people who made charitable donations found that “keeping taxes down” ranked dead last on a list of seven of reasons people gave for giving, and was cited as the second least likely factor to influence giving (even behind “being encouraged by an employer”).

Ironically, it is the very rich—those for whom the estate tax ostensibly exists—who have the means, access, and inclination to avoid it. The very wealthy are precisely those who tend to be most sensitive to the need for estate planning, and also to be those with money to spend on high-priced lawyers and accountants.

IRS data suggest that this is money well spent, since the very wealthiest estates actually wind up paying a lower percentage of their net value in federal estate taxes than more modest estates. Indeed, the estates that pay out the highest percentage of their value in federal estate tax are those worth between $5 million and $19 million. These estates ultimately pay over 40 percent more of their net value in federal estate taxes than do estates whose value is $20 million and higher.

So, what should people do when they wake up one day to find that the government has magically declared them “rich”? The same things that those who knew they were rich all along should do:

· Plan Your Estate. Note to baby boomers: You will not live forever. Estate planning is, thus, absolutely essential for those who are responsible about their money and who care about supporting their families and the causes and institutions they value. Choosing among the various strategies and options requires intelligence and skill. Estate planning can, however, take on a life of its own, almost like a game. At a certain point, you should ask yourself whether you are just paying the money to the lawyers and the accountants so that you don’t have to pay the same money to the IRS. When you reach that point, proceed directly to the next paragraph.

· Spend it. Spend it on yourself, your family, and the people and institutions you love and that made your life so (genuinely) rich. Use the full $10,000 per person exemption every year. Ask yourself whether it is better to have $1,467,929.00 in the bank than to have $1,457,929.00 and have your grandchild going to a better school.